How A High-Earning Couple Got Roth IRAs And You Can Too

Tax engineers: Dennis and Anne Frailey in their Fairview, Tex. home with years of spreadsheets and financial records.

This story appears in the Feb. 27, 2012 issue of Forbes magazine, p. 56, titled “Roths For The Rich.”

As soon as Congress created the Roth individual retirement account in 1997, Dennis Frailey wanted one. He saw immediately how a Roth, which allows money to grow and be withdrawn tax free, could help him manage his tax bill in retirement. “In my alternative life I should have been a financial planner,’’ says Frailey, a 67-year-old Ph.D. software engineer who since 1980 has used his own spreadsheets to track his spending, investments and taxes and to pro­ject his retirement income.

Just one hitch: Congress decreed highly paid workers couldn’t contribute to Roth IRAs, and Frailey always earned too much from his job at Raytheon in Plano, Tex. to qualify. (Now retired from the corporate world, he teaches part time at Southern Methodist University.)

Fifteen years later high earners still can’t make annual contributions to Roth IRAs–directly. But today they can shovel as much as $12,000 in 2011 and 2012 contributions per person into Roth IRAs by dancing a little two-step through the Roth’s back door.

First, they must contribute aftertax money to a traditional IRA. Then they can move that money into a Roth through a “conversion.” This works ­because Congress, in its wisdom, ended income limits on Roth conversions as of 2010 while leaving income limits on contributions in place. Frailey himself did a backdoor Roth in 2010, the first year it was allowed (and his last year at Raytheon). His wife, Anne, 60, a software engineer for the federal government, is now making backdoor Roth contributions. “It really pays off for people to learn about these things,’’ he says.

Wait a minute. Doesn’t a Roth conversion usually mean paying a big tax bill? Not if you first execute yet another, even more arcane maneuver—namely, rolling any pretax contributions and earnings sitting in your traditional IRAs into a 401(k) plan.

Is all this shuffling of money to snag a tax benefit legit? The lawyers and CPAs we interviewed insist it is. To be safe we also asked the Internal Revenue Service. A spokesman said the tax agency knows about backdoor Roths and doesn’t object, so long as they’re “done correctly” and reported on your 1040. Here’s what you need to know.

Why you want a Roth IRA. There are three types of retirement ­account contributions—before tax, traditional aftertax and Roth. Money you put into an IRA or 401(k) before it’s been subjected to income tax grows tax deferred, but all withdrawals in retirement are taxed as ordinary income at a current top rate of 35%. Traditional aftertax contributions also grow tax deferred, and when you make withdrawals all earnings (although not your original ­aftertax contribution) are taxed. Roth contributions are made with aftertax money, too, but the earnings in a Roth and all withdrawals in retirement are tax free. So a Roth provides a big tax break on the back end that a traditional aftertax IRA doesn’t.

Moreover, under current law Roth withdrawals aren’t counted for the ­purposes of determining how much of a retiree’s Social Security check is taxed or how much in extra income-based Medicare premiums he has to pay. These extra premiums can come to thousands a year and are likely to grow.

Roths have yet another distinct advantage for affluent families. You must start taking minimum annual distributions from a traditional IRA when you turn 70.5, but you don’t have to take any withdrawals from a Roth. Instead, you can leave the whole account to your kids (or better yet, grandkids) who can then stretch out tax-free withdrawals over their own projected life spans.

Front-door contributions. To the extent you or your spouse have earned income, you can contribute $5,000 per person a year ($6,000 if you’re 50 or older) to either a deductible, nondeductible or Roth IRA. You have until Apr. 17 to make contributions for calendar year 2011. So in theory a 50-plus couple could make total contributions of $24,000 for 2011 and 2012 right now.